To understand what smart contracts are, we first define what a contract is. A Contract is a written or spoken agreement, especially one concerning employment, sales, or tenancy, which is intended to be enforceable by law. The essentials necessary to create a valid contract include:
- Mutual obligation
- Intention to create a legal relationship
These formal contracts are carried out by people and they have set the terms and conditions for the contract.
Smart contracts are self-executing contracts with the terms of the agreement between buyer and seller being directly written into lines of code. The code and the agreements contained therein exist across a distributed, decentralized blockchain network. Smart contracts can also be defined as agreements wherein execution is automated, usually by computers. Such contracts are designed to ensure performance without recourse to the courts. Automation ensures performance, for better or worse, by excising human discretion from contract execution.
Smart contracts were first proposed in 1994 by Nick Szabo, an American computer scientist who invented a virtual currency called “Bit Gold” in 1998, fully 10 years before the invention of Bitcoin.
The phrase and concept of smart contracts was developed by Szabo with the goal of bringing what he calls the highly evolved practices of contract law and practice to the design of electronic commerce protocols between strangers on the Internet. Smart contracts are a major feature of cryptocurrency and the programming language.
Szabo defined smart contracts as computerized transaction protocols that execute terms of a contract. He wanted to extend the functionality of electronic transaction methods, such as POS (point of sale), to the digital realm.
These contracts help you exchange money, property, shares, or anything of value in a transparent, conflict-free way while avoiding the services of a middleman.
The best way to describe smart contracts is to compare the technology to a vending machine. Ordinarily, you would go to a lawyer or a notary, pay them, and wait while you get the document. With smart contracts, you simply drop a bitcoin into the vending machine (i.e. ledger), and your escrow, driver’s license, or whatever drops into your account. More so, smart contracts not only define the rules and penalties around an agreement in the same way that a traditional contract does, but also automatically enforce those obligations.
The key properties of smart contracts are:
Autonomy implies that after a smart contact launches, the deal initiator does not have to participate any more in the process. Smart contracts are not focused on one central server but are distributed by various network points so they can be referred to as being decentralized. Auto-sufficiency supposes that contracts are able to collect money, realize transactions, distribute resources, issue and spend funds to allow a larger capacity of storage and computation power.
Having understood what smart contracts are, we now address the potential legal implications the contract has on the parties. For a normal written contract the description of the parties, their obligations to each other, their description of the subject matter are all stated in the contract. Thus creating the legal obligations.
The emerging issue of smart contracts is what happens when an agreement can be enforced not by public law enforcers, but through the terms and mechanisms set forth in the terms of the contract itself. The typical legal action for breach of contract involves an aggrieved party going to a court of law or equity to demand money damages, restitution, or specific performance. With a smart contract, the aggrieved party will need to go to the court to remedy a contract that has already been executed or is in the process of being performed. This is because, by definition, a strong smart contract is already executed or in the process of being executed by the time the court hears the case. So the remedy must come after the fact to undo or alter the agreement in some way.
It can be quite problematic to enforce the disputes that may arise from these types of contracts. There may be no central administering authority to decide a dispute between participants to a smart contract, forcing them to seek recourse in the courts. There may be no obvious defendant against whom legal action could be brought. For example, who would be responsible for system operational defects, corrupted messages, or defective programmer logic that led to non-performance (or unexpected performance) of a smart contract? It may be unclear if a legally binding contract exists between participants to a smart contract if they seek legal redress for breach of contract in the courts. Even if there is no clear contract, a smart contract transaction may itself have an effect on property rights – for instance, if it is a register of legal ownership – and so any dispute would need to be resolved as between the rival claimants to those property rights. Transactions using some digital ledger technologies, especially blockchains, can be conducted pseudonymously. If a dispute arose, how would an aggrieved participant to a permissionless blockchain identify the other party to a smart contract in order to bring legal proceedings against it? Would a court regard a smart contract hosted on a blockchain as having legally binding effect if it is simply not possible to identify who the other contracting party to it is? There may be difficulties in proving the existence or content of a smart contract in court proceedings where evidence exists only in electronic format on a distributed ledger or elsewhere. Enforcement of a court judgment or arbitration award in respect of a transaction using distributed ledger technologies may be problematic. Even where dispute resolution mechanisms exist for distributed ledger technologies, there may be problems applying them beyond the “trust boundaries”, that is, where they interact with third party systems.
Some of the approaches that may be useful may include where a distributed ledger technology has a central administering authority with the power to insert arbitrary or remedial transactions into that ledger (a permissioned ledger might provide for this), the parties might, for example, agree that this authority has the power to determine any disputes. This agreement might be contained in a particular smart contract, or it could be part of the terms and conditions accepted by the participant when it acquires an identity or otherwise participates in the particular ledger. The authority would need protection from disputes arising from its exercise of these powers. Again, that could be a term of a smart contract or the terms and conditions of the permissioned ledger.
- a distributed ledger has no central administering authority (whether the distributed ledger is permissioned or permissionless); or
- the parties do not wish to delegate dispute resolution to it; or
- it is logically impossible to unwind a transaction without the participation of a quorum of all of the participants, then the problems are more acute: it may be impossible to unwind a transaction even if clearly desired by the direct parties. A dispute resolution mechanism built into the smart contract itself could provide a solution.
Such a mechanism would need the following characteristics:
- a provision in the contract code that causes delegation to an arbitrator, which would be triggered under rules encoded in the smart contract: for example by both parties asserting a defect and nominating the arbitrating entity;
- a provision in the contract natural language version agreeing to submit disputes to arbitration: this assumes that there is a natural language version of the contract and that it matches the delegation mechanism in the contract code
- a forum for arbitration, which could be administered centrally, or via a relevant ledger, or by use of one of the many existing and experienced fora. The forum would identify these essential components:–
- a body of rules for the arbitration
- pool of possible arbitrators, who could vary from persons able to provide expert determination at a low fee to high-value arbitrators capable of overseeing complex disputes
- an administration capable of managing the cases as they are filed and decided.
A dispute resolution mechanism embedded in a smart contract reflects the advantages of a smart contract over a traditional contract: enforcement of the dispute resolution process and the consequent decision could be made automatic and integrated into the ledger. Not only would smart contracts deliver finality of agreed actions in performance, but also those actions and events that generate discord for whatever reason – disagreement over intent, bugs in the code, external exigencies could also achieve finality through a formal process. Such a mechanism might also provide a partial solution to the complexities of cross-jurisdictional trade. By using a common body of rules, the parties can agree to a rule base that is aligned across borders and legally acceptable within both jurisdictions.